Tax Deferred Annuity

What is Tax-Deferred Annuity?

A tax-deferred annuity is an employee retirement benefit plan where both an employer and its employee contributes to the saving plan for the purpose of long term investment growth and it offers various benefits like age 50 plus catch up, lifetime catch up, taxes and investment options.

Explanation

It is a big advantage that tax is not to be paid right now, so we can call it as a tax-sheltered annuityA Tax-sheltered AnnuityTax-Sheltered Annuity (TSA) is a form of retirement savings plan in which the contributions made are from the untaxed income. Therefore the contributions and interest accrued on the same are not taxed during savings, while only the withdrawals are taxed.read more. This type of annuity is of two types, first single payment annuity and second is a series of payment annuity. In single payment annuity, onetime payment is made by the investor, whereas, in a series of payment, annuity payments are made at equal intervals.

• A tax-deferred annuity plan generally uses to manage by Insurance companies.
• Many types of annuities exist in the market with different features and benefits.
• As per the Statutory rules till the age of 59.5, investors cannot withdraw money if the investor does so, then penalty may impose for before withdrawal.
• The interest amount accumulates and tax-deferredTax-deferredDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more until the money is received by the investor.
• Some companies give an option to their employees to contribute to a tax-deferred annuity plan from their salary for their Long term growth.

Formula

Given below is the formula to calculate deferred tax annuity.

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For eg:
Source: Tax Deferred Annuity (wallstreetmojo.com)

• A = Amount
• i = Interest Rate
• n = Number of Payments

Examples of Tax-Deferred Annuity

Given below are the example of deferred annuity.

Example #1

Mr. Y initiated a deposit from his employer of $ 500 per month starting at the age of 55 until Mr. Y retire, say retirement age is 65. If the interest rate is 3% compounded monthly, what will be the value of the annuity at the end of 10 years?

• Amount (A): $500
• Interest Rate (i): 0.0025
• Number of Payments (n): 120

Here, i = 3% / 12 = 0.0025

n = 12*10 =120

Calculation of annuity value is as follows –

• Deferred Tax Annuity = $500*(1+0.0025)¹²⁰ – 1 /0.0025
• =$69,870.71

Thus, the annuity at the end of 10 years of Mr. Y will be $ 69870.71/-

Example #2

Mr. Pawan initiated a deposit from his employer of $ 3000 quarterly starting at the age of 50 until Mr. Pawan retire, say retirement age is 60 years. If the interest rate is 6% compounded quarterlyCompounded QuarterlyThe compounding quarterly formula depicts the total interest an investor can earn on investment or financial product if the interest is payable quarterly and reinvested in the scheme. It considers the principal amount, quarterly compounded rate of interest and the number of periods for computation.read more, what will be the value of the annuity at the end of 10 years?

• Amount (A): $3,000
• Interest Rate (i): 0.015
• Number of Payments (n): 40

Here, i = 6% / 4 = 0.015

n = 4*10 = 40

Calculation of annuity value is as follows –

• Deferred Tax Annuity = $3000*(1+0.015)⁴⁰– 1 / 0.015
• =$162,804

Thus, the annuity at the end of 10 years of Mr. Pawan will be $162,804/-

Example #3

Mr. Devanand initiated a deposit from an employer of $5000 half-yearly starting at the age of 45 until Mr. Devanand retires, say at the age of 60. Suppose the interest rate is 8% compounded half-yearly. What will be the value of the annuity at the end of 15 years?

• Amount (A): $5,000
• Interest Rate (i): 0.020
• Number of Payments (n): 30

Here, i = 4% / 2 = 0.020

n = 2*15 = 30

Calculation of annuity value is as follows –

• Deferred Tax Annuity = $5000*(1+0.020)³⁰– 1 / 0.020
• =$202,840.40

Thus, the annuity at the end of 15 years of Mr. Devanand will be $ 202840.40/-

Example #4

Mr. Abhinay initiated a deposit from his employer of $ 8000 yearly starting at the age of 55 until Mr. Abhinay retires, say the retirement age is 60 years. Suppose the interest rate is 8 % compounded yearly. What will be the value of the annuity at the end of 5 years?

• Amount (A): $8,000
• Interest Rate (i): 0.08
• Number of Payments (n): 5

Calculation of annuity value is as follows –

• Deferred Tax Annuity = $8000*(1+0.08)⁵– 1 / 0.08
• =$46932.81

Thus, the annuity at the end of 5 years of Mr. Abhinay will be $ 46932.81/-

Advantages of Tax-Deferred Annuity

• The investor has to pay tax only once when he withdraws the annuity amount.
• The contribution amount has no limitation whatever amount the investor wants to invest; he can invest.
• This annuity provides a lifetime benefit for the investor and his/her spouse.
• This annuity having death benefit suppose the investor dies in between the annuity contract; the amount will be received by the nomineeNomineeA nominee is an individual or entity that under financial terms gains access to assets and securities, including bank deposits, real property, and stocks, on behalf of the original owner. While serving as a trustee or guardian to safeguard assets in the absence of the actual owner, the designated party gets powers to conduct financial transactions. read more.
• Most of the insurance companies provide a guarantee for the loss of principal.

Disadvantages of Tax-Deferred Annuity

• The investor has to bear additional charges like commission, administrative fees, funding expenses, etc.
• High income can be earned by the investor by investing money in the stock market instead of investing in an annuity.
• An investor can not withdraw money during the annuity term, and if withdrawn, then the penalty has to be paid for early withdrawal.

Withdrawal Options

When an investor reaches the age of 59.5, then payment can be received in one of three ways described below:

1. Lump-Sum: In this option, a onetime single taxable payment will be received by the investor.
2. AnnuitizationAnnuitizationAnnuitization is a method by which ‘annuity’ investments are converted into systematic income payments at regular intervals. In other words, it is a systematic income plan wherein the holder of the Annuity (a contract made between the insurance company and the holder of the insurance who makes a lump sum payment or a series of payments to start receiving a fixed income at regular intervals) triggers the income payments.read more: In this option, monthly, quarterly, or yearly payment is received by the investor until death.
3. Systematic Withdrawal: In this option, the amount will be paid periodically.

Conclusion

• Deferred Tax Annuity plan is a kind of investment plan where income tax on investment incomeIncome Tax On Investment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more is not charged during the investment term, and any tax liability thereof is postponed until maturity.
• A tax-deferred annuity is a contract between the investor and an insurance company in which the insurance company receives money from an investor and pays interest on a pre-determined rate for a fixed period.
• The investor enters into this contract to save money for the future.
• The investor receives a tax benefitTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more for the contract period in the form of tax-deferred on earning.
• Income from this contract will be taxed as ordinary income on the withdrawal of money.
• On the death of the investor, the money will be received by the beneficiary and taxable in the hands of the beneficiary.

Recommended Articles

This has been a guide to what is Tax-Deferred Annuity and its definition. Here we discuss the formula of tax-deferred annuities along with calculation examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

• Ordinary Annuity | Examples
• Proportional Tax
• Calculate Future Value of Annuity Due
• Annuity vs Lump Sum